Assignment of Rents in Bankruptcy

Note: Please also see the July 1995 Update to this article.

Introduction

The New Jersey state courts have been less friendly to lenders. A recent Appellate Division decision has upheld the long standing rule that a receiver will not be appointed unless the lender can prove cause. Furthermore, one Chancery Division Judge has enjoined a lender from enforcing an assignment of rents absent cause which would support the appointment of a receiver.

Based on the current state of the law, Connell Foley LLP is advising clients to review their assignment of rent form to be sure the language constitutes an unequivocal transfer of title to the rents and not merely a security interest. The borrower may be granted a revocable license to collect the rents. Upon default the lender should revoke the license and demand payment of the rents from the tenants. The lender can seek the appointment of a receiver if there is good cause or if the tenants refuse to pay the rents to the lender.

Federal Cases

The Third Circuit gave lenders an even greater victory in Commerce Bank v. Mountain View Village, 5 F.3d 34 (3rd Cir. 1993). That case applied Pennsylvania law and held that where a lender had exercised an assignment of rents by notifying tenants and had been collecting rents for over three months prior to bankruptcy, the debtor had no interest in the rents. Pennsylvania is a title theory state wherein the mortgage is considered a conveyance of the fee, not just the granting of a lien. Thus, the rents which had likewise had been conveyed to the lender, were not property of the estate and were not available for use by the debtor in a plan of reorganization.

Bankruptcy Judge Winfield followed Commerce Bank and, applying New Jersey law, held that an assignment of rents was absolute so that the debtor had no interest in the rents post petition. Her decision was affirmed on appeal to the District Court. In re Glen Properties, 1993 WL 669239 (D.N.J. 1993). The lender had commenced a foreclosure action and moved for the appointment of a receiver. The motion was granted but before the receiver took any action, the debtor filed a bankruptcy petition. The language of the assignments was crucial to the outcome. The Bankruptcy Court and the District Court both found that the assignments presently assigned all leases and the rents they produced to the lender. The borrower was granted a license to collect the rents until an event of default. Upon default the license terminated and the borrower had no present interest in the rents at the time of bankruptcy. Although the debtor would be entitled to the rents after the loan had been satisfied, that right was held to be a contingent future interest not recognized in bankruptcy.

Two recent unpublished opinions have addressed the right to rents, one favorable to the lender, the other not a total victory. In In re Edgebrook Realty Associates, Inc., Case No. 93-29465 Judge Winfield in a bench opinion issued February 3, 1994 again held that the assignment of rents left the debtor with no interest in them post petition, only this time she was applying New York law. She found that New York courts distinguish between a pledge of rents, wherein the creditor must take some action following default to divest the borrower of the right to the rents, and an absolute assignment, wherein the lender is vested of a present interest in the rents at the time of the assignment. Her review of New York cases led her to the conclusion that New York courts go out of their way to find pledge as opposed to an absolute assignment. Nevertheless, construing the language of the assignment in that case, she found it was an absolute assignment. She also stated that were she to construe the assignment as a pledge, she would still find that the debtor had no present interest because the lender had commenced a foreclosure and sought the appointment of a receiver. That action was enough to "cutoff the rights of the debtor to those rents and caused them to vest in the mortgagee."

Judge Winfield disagreed with an opinion of Bankruptcy Judge Schwartzberg in In re Constable Plaza Associates, 125 B.R. 98 (Bankr. S.D.N.Y. 1991). In that case the lender had obtained the appointment of a receiver which vested its rights to the rents, however, Judge Schwartzberg held that the Debtor's right to the rents after the loan had been satisfied constituted property of the estate under § 541 of the Bankruptcy Code. Thus, the rents were cash collateral which the Debtor could use upon entry of an order giving the lender adequate protection. Judge Winfield disagreed with Judge Schwartzberg's analysis. She held that the Debtor's right to rents after satisfaction of the mortgage debt was speculative, at best a future interest, and that the Debtor had no rights in the current rent stream. Thus, she concluded that the rents were not property of the Debtor's estate and that the receiver could continue collecting the rents, but had to use the rents to maintain the property.

In an opinion rendered July 22, 1994, Bankruptcy Judge Ferguson reached a different result. She held that the language of the assignment created a security interest in the rents, not an absolute assignment, so that the rents were property of the estate and cash collateral which the debtor could use. In re John Donato, Jr., Case No 94-33838. In that case there were three lenders objecting to the debtor's use of cash collateral from several buildings. Even though two of the lenders had obtained the appointment of a receiver prepetition, Judge Ferguson examined the language of the assignments and found them to be ambiguous. Although they purported to convey title to the rents, they also stated that the assignment was as additional security for the loan. In such case, Judge Ferguson construed the ambiguous language against the lender which had drafted the document and found that the assignments were meant as security agreements. Thus, she found that the debtor retained an interest in the rents, despite the appointment of a receiver. The third lender had induced the borrower to sign a consent order for the appointment of a receiver. That order contained unequivocal language that the debtor had made an absolute assignment of the rents, not merely as security. For that lender, Judge Ferguson held that the rents from its mortgaged premises were not property of the estate.

Based upon the above federal cases, Connell Foley LLP is recommending that lenders review their assignment of rent forms and make sure that the language unequivocally transfers title to the rents to the lender, not merely a security interest. If the lender does not want the administrative burden of a lock box, the lender may grant the borrower a revocable license to collect the rents. Upon default the license may be revoked. Should the borrower file bankruptcy, the rents will not be property of the bankruptcy estate and will not be available for use by the debtor in a plan of reorganization. However, the lender will have to use the rents to maintain the property.

New Jersey State Court Cases

Another troubling unpublished decision is the bench opinion of Chancery Judge Lesemann in The Prudential Insurance Company of America v. MBM Associates, Docket No. F-5320-94 issued June 16, 1994. In that case the lender exercised an assignment of rents by hiring a property manager, taking physical possession of the property and hand delivering notices to the tenants to pay rents to the lender's property manager. Judge Lesemann, anticipating the ruling in Barclays Bank, declined to follow Hocroft and held that a contractual provision for the appointment of a receiver did not automatically entitle the lender to the appointment of a receiver without cause. Furthermore, he ruled that the same policy requires that cause also exist before a lender exercise a self-help assignment of rents. In that case, finding no justification for the lender's action despite the maturity of the loan, he ordered the removal of the lender's property manager and enjoined the lender from interfering with the borrower's management of the property. The Judge accepted the borrower's description of the lender's action as "a commando raid". Judge Lesemann said, "I am not ready to say that under no circumstances could a mortgagee ever effect a rent assignment by itself without some prior judicial proceeding. I would think in 99.9 percent of the cases that is probably so. But again, that kind of broad decision, i.e., one can never do something, is really not before me. But I am prepared to say and to hold, and I do find and I do hold, that at the very least when a mortgagee attempts to do what Prudential did here and the mortgagor properly comes to court and disputes the right of the mortgagee to do that, that at the very least at that stage of the proceeding the mortgagee must justify its action and must indicate that it has a right to effect that assignment and baring some other consideration not present here, that standard should be essentially the same as that applicable to the appointment of a rent receiver."

Is Self-Help the Answer?

Some caution should be exercised before sending a demand letter to tenants. First, the lender should be aware of the environmental conditions on the property. Collecting rents could lead to the lender being considered an operator of the property under CERCLA or state environmental laws. Second, potential lender liability claims should be considered. For example if a major tenant is about to renew a lease, receipt of a demand letter from the lender may scare that tenant away. The borrower will undoubtedly seek to lay the blame at the lender's doorstep. Third, the lender must be prepared to manage the property. If the rents are not sufficient to cover expenses and debt service, the property will soon suffer if not maintained. It will be difficult for the lender to avoid becoming mortgagee in possession which carries with it the obligations to account for the rents and to maintain the property.

To summarize, based on the current Federal and state decisions, Connell Foley LLP recommends that its lender clients review their assignment of rents forms to be sure they unequivocally assign the rents absolutely and not merely as security. The borrower may be given a revocable license to collect the rents. Upon an event of default, Connell Foley LLP recommends exercising self-help by revoking the license and demanding the rents from the tenants. Application for the appointment of a receiver may be made where circumstances warrant, such as if tenants are recalcitrant in paying the rents to the lender. Any action should be taken cautiously after considering environmental, lender liability and management issues.